Help us put Harry Markowitz on the hot seat

Anyone who has ever taken a finance course is likely familiar with the name Harry Markowitz. The Nobel Prize winner is widely credited with developing the framework upon which much of modern portfolio theory is based.

What you may not know is that Markowitz is still very active in the finance profession both as an academic and as a consultant. He currently teaches at the University of California San Diego and advises a plethora of firms. On May 11th, he’s one of three Nobel Laureates who will be addressing institutional investors and hedge fund managers at the Global Absolute Return Congress (Global ARC) in San Francisco.

As a co-chair of this event, I have been tasked with interviewing Markowitz and finding out his views on the past two years in financial markets. I’ve got a few ideas, but I need your help. Please send me any questions you might have for the Professor. An affable and relaxed kind of guy, Markowitz has encouraged me to come up with some hum-dingers for him. So please don’t hold back. Email me at editor@allaboutalpha.com.

Why do so HFoF allocate so few assets to global macro, especially compared to the early ’90s and even less to managed futures?

Would it be fair to suggest that in the taxonomy of investing HFoFs consider themselves “better” than CTAs somehow due to the difference in regulation or background of the different “classes” of investors?

As the main inputs to any mean/variance model are mean and variance, what are your thoughts on the recent past given alternative investments, and that these historical estimates have shown to be wildly wrong? An optimizer will obviously allocate to alternatives, but without understanding what drives these returns, is this not totally misleading? For example, hedge funds use leverage and tricks like collecting option premium to looks smart and fool the Sharpe ratio, and occasionally even tell their investors about it. Private equity instead chooses to tell investors basically nothing, and when they do it is 90 days too late and the valuations are, um, suspect. The wonderfully uncorrelated pvt equity returns everybody brags about at cocktail parties are very correlated if adjusted for leverage and time lags. The distributions of these returns are far from normal as well. So how do we adjust our expectations of an optimizer, or the inputs to the model, to incorporate these problems looking forward?

Warren Buffet said: “Wide diversification is only required when investors do not understand what they are doing”. Do you agree? After 50+ years of diversification theory what do you believe are MPT’s strongest tenants? Contrast MPT in the frames of 1952, 2009, and Mr. Buffet’s style of “Value Investing”

I think the biggest issue is that too many investors (and investment advisors/consultants) took the output from a mean-variance optimization as gospel. Just about everyone realizes (now) that this is not a good idea. One solution is to use more intuition (i.e. a little more art and a little less science). Most academics aren’t going to concede this as the solution, so it would be interesting to hear from the man himself what he thinks the solution is to the shortcomings of MPT.

There are a few obvious adjustments that can be made such as accounting for higher moments (skewness and kurtosis) and adjusting for stale pricing of private investments (lagged pricing regressions, ARCH, GARCH, etc.). Unfortunately most investors/advisors do not have the software at their fingertips that make such adjustments. Supposedly JP Morgan has developed this and I am trying to line up a meeting with them, but haven’t scheduled anything yet.

A few other questions that I think would be interesting are;

Can MPT, or some other model account for changing correlations?

at what level does Markowitz think MPT should be used: for example, is the best use to set broad asset allocation targets (stocks, bonds and real assets), or should it be used to model finely categorized investments (large cap vs. small cap stocks, investment grade vs. non-investment grade bonds, etc.).

thoughts on other concepts developed to building portoflio’s such as Black-Litterman and Bill Sharpe’s expected utility.